Most investors have undoubtedly heard the advice to “invest for the long term,” but that’s only part of the equation for building wealth over time. An important key to long-term wealth accumulation lies in the reinvestment of dividends and capital gains.
The Power of Compounding
Let’s take a look at why this is so. Say an investor buys 1,000 shares of a bond mutual fund with a share price of $10 and a yield of 4%. For the sake of clarity, we’ll assume that the fund’s share price and yield don’t change. The investor receives $400 a year in income from the fund, or $33.33 each month.
If the investor chooses to take the income in the form of a check each month, they will have that $33.33 available to spend. However, the investor will also maintain their original 1,000 shares with no opportunity to benefit from the power of compounding.
On the other hand, consider what happens to the investor’s account when this income is reinvested. The first month, that $33.33 buys the investor new shares. Instead of owning 1,000, they own 1,003.33. The next month, that same 4% yield brings in $33.44, which again is invested back into the fund. Each month, the amount of income received grows by a little bit, and each time it buys a few more shares than it did the month before.
This may not sound like much. After all, what good are that extra 11 cents in the first month? But over time, the extra cash from reinvestment can really add up:
- By the end of the first year, for example, the investor will have 1,037.28 shares (worth $10,372.80) and their monthly income will have risen to $34.58.
- At the end of Year 5, the account will have grown to 1,216.94 shares ($12,169.40), and the same 4% yield will bring in $40.56 each month.
- After 10 years, the investor would have 1,485.88 shares ($14,858.80), with a monthly income of $49.53.
The math continues in the same fashion no matter how far you extend the time period, illustrating that the investor who chooses to reinvest their income back into the fund comes out far ahead of the investor who takes the income in cash.
It’s also important to keep in mind that the process of reinvestment doesn’t work quite as cleanly in real life as in the example above. Mutual funds generally present lower volatility and risk than the shares of an individual stock but even conservatively managed funds experience share price fluctuation over time. As a result, the principal in the example above wouldn’t be exactly $14,858.80—it could be higher or lower depending on market conditions.
There is one advantage to this, however: if the share price of the fund drops, the investor who regularly reinvests automatically buys buy more shares. Conversely, when the share price goes up, the investor who reinvests his dividends buys fewer shares. This is called “dollar-cost averaging,” and it automates buying high and selling low.
It should be said that many people, especially those in retirement, need to take the income from their investments to supplement Social Security, their pensions, or other sources of retirement income. But if you don’t have an immediate need for cash in hand, reinvestment is almost always the wiser course. Over time, it's the best way to build wealth.
- Reinvestment of dividends and capital gains is an essential component
of wealth building.
- When investors reinvest income, they take advantage of the
power of compounding to build their investments and future dividends.
- Investors who choose to reinvest dividends generally earn more over time than those who take their dividends in cash.
- However, no investment is without risk. Although mutual funds offer lower volatility than investing in single stocks, even conservatively managed funds may lose value.